You have been asked by the president of your company to evaluate the proposed ac

Question

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck’s basic price is $50,000 and it will cost another $10,000 to modify it for special use by your firm. The truck falls into a five-year depreciation class and will be depreciated to zero over the five-year period. The truck is actually expected to be sold for $20,000 after three years when the project is ended. Use of the truck will require an increase in net working capital of $2,000 (spare parts). The truck will have no effect on revenue, but it is expected to save the firm $22,000 per year in before-tax operating costs, mainly labor. The firms marginal tax rate is 40 percent and the required rate of return on the project is 13 percent. What should you do?

Explanation / Answer

The base price of the truck is 50000 and 10000 is to modify the truck for firms special use
thus total Fixed cost investment = FCinv = 50000+10000 = 60000
and working capital increase = WCinv = 2000
Initial Outlay = FCinv + Wcinv = 60000+2000 = 62000

Truck will be depreciated to zero salvage value after 5 years
depreciation = 60000 / 5 = 12000

The revenue is expected to be same but cost is expected to save 22000 per year thus its a cash inflow
After tax operating cashflow = cost-depreciation*(1-tax)+depreciation
=22000-12000*(1-0.4) + 12000
=18000

The bookvalue of truck at the end of three year = 60000-(3*12000)=24000
Salvage value = 20000
Terminal year cashflow = salvage+WCinv - tax*(salvage-bookvalue)
=20000+2000 - 0.4*(20000-24000)
=22000 - (-1600)
=23600
(and this will be added to the final year cashflow thus it will be 23600+18000=41600)

As the project will end in three years, NPV at 13% required rate of return is:

Years

Cashflows

0

-62000

1

18000

2

18000

3

41600

NPV at 13%

-$2,781.65

IRR

10.391%

The NPV of a project is negative and IRR is less than required rate of return the project shouldnt be accepted.

Years

Cashflows

0

-62000

1

18000

2

18000

3

41600

NPV at 13%

-$2,781.65

IRR

10.391%

The NPV of the project can be found by inserting cashflows in the financial calculator and by presing CPT and NPV at 13% and CPT I/Y for IRR

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